15 Feb Decisions and outcomes
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It is very easy, when faced with a decision which went well, even if by accident, to ascribe your success to skill. Conversely, if it went badly, it is either your bad luck or someone else’s fault. We have clients who have come to us with large positions in single companies which have contributed significantly to their wealth. In some cases they still work there and awards of share options are part of their compensation package. Often they represent the majority of their assets and the share price has risen in most years.
Nevertheless, where their employment terms permit, we usually recommend that they liquidate these holdings as soon as they are able to do so. Those with long memories may recall the tragic tale of those employees of Enron who lost not only their jobs but also their investments and their pension benefits when the company failed spectacularly in 2001. Voluntarily buying shares in your employer, as many did, is one thing. However, discovering that more than half the value of the pension scheme was also held in it when that stock falls 94% in under a year is something else entirely. It was especially galling for the employees of a company acquired by Enron a few years previously and who lost hundreds of thousands of dollars as a result.
While this is an extreme case, there are many instances of companies experiencing sudden and large falls in their share price, sometimes through events which most shareholders would have no way of foreseeing. In recent years Facebook (privacy concerns), Volkswagen (emissions scandal) and BP (Gulf of Mexico oil spill) have all experienced serious share price drops following the breaking of news stories.
Getting rich often involves taking a large undiversified risk. Whether by betting your entire net worth on a spin of a roulette wheel like Ashley Revell in 2004 (he won and doubled his money) or investing in a startup which a few years later lists or is bought up by a multinational, there is a significant risk of total loss. While the winners of such bets become household names, the countless losers disappear into obscurity unless they happen to make it big at a later date; at that point they may well be hailed as geniuses.
The fact is that what made you rich is not necessarily going to keep you from becoming poor. While it is much less exciting, the best way to retain your wealth is to diversify as widely as possible so that if and when the asset in which your fortune was made fails in the future, your exposure to it is sufficiently small that it has a minimal impact on your circumstances.
Ashley Revell, by the way, used his winnings to set up an online poker company. It went out of business in 2012.
The world is an uncertain place. Every day things happen which were not predicted and every day things which were predicted do not happen. This is true even of highly qualified professionals – economists frequently predict recessions yet sometimes they happen and sometimes they don’t.
Trying to plan in such an environment is difficult. However, the fact that something is hard to do does not, whatever Homer Simpson might say, make it not worth doing. The solution is to make assumptions about the future that are, as the international Certified Financial Planner™ standards say, ‘reasoned and reasonable’. It is also to recognise that even if they meet these two standards, they are still likely to be wrong. The fact that they turn out to be wrong, particularly over a short period such as a year, does not invalidate their use. The Bank of England uses assumptions to build its financial models for predicting a number of economic variables. A study by its Independent Evaluation Office in 2015 found that some of its forecast errors, such as for unemployment (used to guide interest rate policy) were ‘relatively large’ but that does not invalidate the process. Interestingly, the same report found that private sector forecasters also became less accurate in the same period. While nobody suggests that this shows forecasting to have no value, such outcomes do remind us that there is scope to learn from them and to seek ways to improve the process.
Whenever we meet with a potential new client they usually have a collection of assets which they have accumulated over the years. Sometimes they hold a portfolio which is managed for them by another company or they have made the decisions themselves as to what to buy and when. In either case, it is very easy to look at each one in isolation and, particularly if it has performed poorly, to use that fact as evidence for why they need to appoint us as their adviser. In reality, this is a poor approach to decision making.
First, any diversified portfolio will normally contain something which is not performing the same as the other assets in it – otherwise it is not diversified. Second, the fact that their holding of gold, Bitcoin, a buy to let property, a lottery ticket or an obscure mining stock in Australia has performed well or badly to date has certainly affected their current net worth. However, what they hold now is not relevant to what they should hold to achieve their future goals so our planning is based on the value of what they have rather than its nature. Third, their circumstances and/or their goals may have changed in the period since they acquired it to the extent that a different approach may now be more appropriate for the future.
The same applies to liabilities. One of the decisions that anyone taking out a loan needs to make is whether to opt for a fixed or variable rate. Apparently the difference over a typical 25-year mortgage term is minimal but in the short term, it can be huge. Opting for a fixed rate because fixing the level of monthly outgoings is important to you is the right decision regardless of what happens to interest rates if having to double your repayments would lead to serious financial problems and possibly repossession. If rates fall then the consequence of being locked in to higher repayments than your neighbour is unwelcome but not ruinous.
In none of these instances is the original decision invalidated just because making a different one would, on that occasion, led to a better outcome.
A financial planner’s starting point is therefore what they are trying to achieve in their life and how much risk they are willing and able to take with their available resources in pursuit of that. Sometimes their goals are likely to be achievable without any changes or with only minor tweaks. In other cases the analysis may indicate that their chances of success can be improved by a more radical restructuring. Either way, the consideration of exactly what they have now comes some time later in the process.